Control Of Risks Incurred By Catastrophe Bonds

Catastrophe bonds are the inevitable result of the development of the capital market and(re) insurance market, which is a powerful tool for managing insurance risks. For nearly 20 years, catastrophe bonds has developed rapidly to become one of the important tools of capital in the world catastrophe reinsurance market, which indicating the rationality and necessity of its existence. It is time to launch catastrophe bond products. At present, the focus of theoretical and practical studies of catastrophe bonds is how to improve the system of catastrophe bonds in China. Catastrophe bonds in China are gradually progressive and the issue that how to control the risk of catastrophe bonds can be an important factor in the process of development of Catastrophe bonds. Catastrophe bonds as a new type of structured finance products have the common risk of structured finance products and its own special risks.All walks of life have discussed on the lack of supervision on securitization of residential mortgage-backed securities and similar products which caused by the international financial crisis in 2008. Catastrophe bonds and mortgage-backed securities were issued by securities, distracting the operations or financing risk. Catastrophe bond is the same as mortgage backed securities, also having serious credit risks. The issue that reflection on supervision of structured financing in the financial crisis has revelation to catastrophe bonds in the future is worthy of attention. Solvency II has established a regulatory framework for securitization of insurance risks. The IAIS issued a revised set of 26 ICPS in October 2011 which for the first time allows insurance companies to transfer risk to capital markets. China Insurance Regulatory Commission issued “Measures for the Administration of the Capital Replenishment of Insurance Companies(Draft)”in November 2014, which clearly defines that policy liabilities-securitization can be as a tool for replenishing capital and insurance companies can issue catastrophe securitization products directly or through the establishment of special purpose entities. Accordingly, insurers could issue bonds to replenish capital and transfer underwriting risks in China. In 2006, the National Development Bank has started preparations for catastrophe bonds issuance, but it has never issued catastrophe bonds. So far, there is no catastrophe bonds issuing example in China. “Measures for the Administration of the Capital Replenishment of Insurance Companies(Draft)”attempted to determine the regulatory framework of catastrophe insurance risk securitization. However, whether it could provide effective systems supporting issuing catastrophe bonds in China in future subjects to debate。This paper clarifies the following problems:(1) whether the operation and risk of financial asset securitization and insurance risk securitization is different?(2) the relationship between systemic risk in financial markets and catastrophe bonds.(3) what is enlightenment of this international financial crisis on the confirmation of the transfer of risk of catastrophe bonds sponsors,SPV’s supervision and investors’ protection?(4) combined with post-financial crisis era of insurance solvency regulation regulatory reform, examining the “Measures for the Administration of the Capital Replenishment of Insurance Companies(Draft)”, this article offers suggestions and recommendations.This paper is divided into five chapters. Chapter I deals with the development of catastrophe bonds and the need to control the risk of catastrophe bonds.Chapter II proceeds from operation mechanism of catastrophe bonds, introducing the risks of catastrophe bonds and discussing the correlation of systemic risk in financial markets and catastrophe bonds. The third chapter discusses catastrophe bonds under the framework of insurance solvency regulation regulation, focusing on risks confirmation of sponsor and improvement of regulatory capital rules. The fourth chapter focuses on catastrophe bonds SPV’s supervision, establishing the future regulatory framework of China. Fifth chapter discusses the legal control of the risk of catastrophe bond investors. The chapters as follows:Chapter I is “Development of catastrophe bonds and the need to control the risk of catastrophe bonds". This chapter deals with the cause of production and development of the Catastrophe bonds market and the necessity and possibility of developing Catastrophe bonds in China market. It is necessary to control the risk of catastrophe bonds. Securitization of insurance risk also known as insurance linked securities is one of the alternative risk transfer tools. Catastrophe bonds are offered directly to capital markets, expanding the risk bearing capacity of the reinsurance market. A catastrophe bond transaction is structured over a specified risk period. The risk insured against could be earthquake, hurricane, typhoon or a portfolio of risks associated with various perils. In each instance, reinsurance is issued and investment income is collected for coverage over the designated risk period. Contained within the designated risk period is the prospect of loss. Loss is defined by a trigger event directly correlated with the risk insured against by virtue of the bond transaction. Typical catastrophe bonds are the options embedded in bonds by insurance companies, forming new types of structured financial products. To address the risk of catastrophe bonds, we must make the necessary legal system design.ChapterⅡis "analysis on risk of Catastrophe bonds ".Based on the analysis of operation mechanism of Catastrophe bonds, this chapter discusses the risks of Catastrophe bonds, which include legal risk, basic risk, counterpart risk and systematic risk, making comparative analysis on assets securitization and Catastrophe bonds on systematic risk. The process of insurance securitization follows traditional forms of securitization. It consists of:(1) creating a “special purpose vehicle”(SPV), and making the SPV as bankruptcy proof as possible;(2)causing the SPV to issue bonds to investors;(3) causing the SPV to enter into reinsurance contracts with ceding insurers or other beneficiaries for an annual payment(“premiums”) and calculating the appropriate amount of premiums;(4) investing the proceeds from the bond distribution and the premiums;(5) ensuring the safety and soundness of the SPV and its investments; and(6)servicing by reliable collection and distribution of the SPV’s net earnings and premiums payments. In addition to the commonalities in their basic structures, asset-backed and liability-based securitisations share other key features. For example, in both arrangements the SPV appears as bankruptcy remote from the originator/sponsor. Although asset-backed and liability-based securitisation arrangements share key structural and operational characteristics-indeed the development of liability-based securitisations drew largely on the experience of asset-backed securitisations- there are some fundamental differences between them. Perhaps the most important difference is that whilst it is common in asset-backed securitisations for the originator to consider the asset transferred to the SPV as a ‘true sale’, in liability-based securitisations the sponsor retains a contractual liability to the underlying policyholders, notwithstanding the economic transfer of the risk. The above means that, whilst asset-backed securitisations could be equated to a sale transaction, liability-based securitisations entail the transfer of an insurance risk against the payment of a premium. Investors in the latter will benefit from the interest yielded by the securities issued by the SPV as well as from the premium paid by the sponsor to the SPV in exchange for providing coverage for the risk ceded. On the other hand, should the risk transferred to the SPV materialise, investors are exposed to losing their investment which is at risk. It should also be noted that insurance risk is generally uncorrelated with the sorts of risks to which other forms of securitisation contracts are exposed.Catastrophe bonds are newly developed alternatives for a risk transfer to capital markets and thus enhance the set of instruments for insurance and reinsurance companies to strengthen their risk management and refinancing options. Catastrophe bonds have a low correlation(if any) with capital markets and other investments. Catastrophe bonds have a comparably high yield in contrast to equally rated corporate bonds. But also new risks emerge that should be regarded by insurance and reinsurance undertakings as well as by investors of Catastrophe bonds products. Catastrophe bonds contain credit risk, basic risk, legal risk, and so on. This chapter discusses the correlation in financial market systemic risk and catastrophe bond. The potential impacts on developed and especially developing economies necessitates the employment of cutting edge and specifically tailored financial solutions to transfer various climatic risks to those in the capital markets who could bear them most economically. In the wake of the recent financial meltdown, however, risk transferring financial technology faces increased skepticism and suspicion with respect to its capability to reduce systemic risks. Rather, financial engineering is blamed for increasing systemic risks, as evidenced by the contribution of collateralized debt obligations(CDOs) and credit default swaps(CDS) to the evolution of the subprime crisis and the collapse of major financial institutions. Given the structuring similarities between catastrophe bonds and CDOs on the one hand, two main questions must urgently be addressed:(1) whether the root causes for the recent financial crisis also apply to and call into question climatic risk shifting technology, and(2) what inherent drawbacks, if any, in Catastrophe bonds should be addressed in order to lower the likelihood of a “climate bubble.” Shedding light on these key questions will contribute to the debate surrounding the future regulatory landscape of risk shifting financial technology in general, and that of catastrophic risk transfer in particular. This should be done by reference to the root cause of the financial crisis, combined with the characteristics of catastrophe bonds, analyzing the risk of catastrophe bonds, drawing on lessons learned, risk prevented. There are several factors for Causing the financial crisis, based on the product rating, trading mechanisms and market speculation, analyzing the impact of catastrophe bonds on systemic risk.The market for catastrophe bonds continues to be very small in comparison to other securitisation markets and, in general, it does not generate additional underlying risks. Catastrophe bonds serve as distribution mechanism for parts of insurance risks for which(re)insurers remain ultimately liable. This limits the potential for systemic risk. Of course, risk securitisation based on poor underwriting and inadequate risk management may potentially create systemic issues similar to the ones observed with the securitisation of sub-prime loans prior to 2007.The third chapter is “the legal control of risk of catastrophe bond sponsors ". Catastrophe bonds can be used to transfer risk or raise funds and may also be used in regulatory capital arbitrage. Catastrophe bonds are different from reinsurance, non-compensation catastrophe bond producing basis risk. “Measures for the Administration of the Capital Replenishment of Insurance Companies(Draft)” does not establish clear and specific rules on confirmation of insurance risk mitigation. We should improve the regulatory capital system to prevent sponsor from regulatory capital arbitrage.The purpose of introducing the definition of SPVs in the Solvency II is to allow alternatives to reinsurance contracts and reinsurance undertakings that provide ‘reinsurance like’ services to insurers and reinsurers. The IAIS issued a revised set of 26 ICPS in October 2011 which for the first time allows insurance companies to transfer risk to capital markets.ICP13 states that where risk transfer to the capital markets is permitted, supervisors should be able to understand the structure and operation of such arrangements and to assess issues which may arise. The associated guidance refers to the special features of fully funded special purpose entities and the particular factors that the supervisor should take into account.Motivation of bank and insurer involved in the securitization are similar, including the use of securitization tool to transfer the business risk, reducing the regulatory capital requirements. From the practice of supervision of asset securitization, the risk transfer should also become one principle of the supervision of securitization of insurance risk. Only contracts with a sufficient risk transfer can be considered as reinsurance contracts. In case they are recognised as reinsurance contracts, they can be part of the technical provisions of the insurer. Solvency II will recognise securitisation and derivatives as effective risk mitigation techniques. The insurance undertaking will need to satisfy supervisors that the intended risk mitigation is indeed present. The framework acknowledges the economic substance of insurance activity and focuses on risk and the management of risk. The SPV transaction should effectively transfer risk from the undertaking to the SPV and thereby to the investors. The amount of risk transfer will determine the amount of credit that the undertaking can take for the SPV in terms of any reduction in the undertaking’s capital requirements or the ability to recognise the recoverable as covering part of the technical provisions. The reinsurer assumes significant insurance risk under the reinsured portions of the underlying reinsurance contracts. It is reasonably possible that the reinsurer may realize a significant loss from the transaction.The fourth chapter is "the legal control of risk of catastrophe bond SPV”. The SPV appears as bankruptcy remote from the originator/sponsor. “Measures for the Administration of the Capital Replenishment of Insurance Companies(Draft)” did not provide a mechanism for the establishment of such a bankruptcy remote entity. The key principles outlined in this article are the basic elements of a regulatory regime pursuant to which(re)insurers, as well as other risk taking entities. Any person setting up a SPV is required to comply with the requirements.(1)SPV’s assets must be held in trust. This principle ensures that there is collateralization of the SPV’s obligations vis-à-vis the cedant.(2)SPV must be fully funded In order to be fully funded, an SPV must commit to hold at all times assets equal to or in excess of the insurance exposure assumed. The requirement to be fully funded should include anticipated fees and expenses. This requirement means that the aggregate exposure of the SPV must have a clearly defined limit.(3)Investors have a subordinated claim on SPV assets. The claim of investors is to be subordinated to the claim of the ceding(re)insurer.(4)The SPV shall be subject to prudent person investment principles The assets held by the SPV shall be invested in accordance with a prudent person standard. The appropriate application of prudent person principles to the investment strategies of SPVs entails the following requirements: assets should reflect the duration of underlying liabilities; assets should be of a high quality and counterparty exposures should be sufficiently diversified; and derivatives should be used only for risk reduction and efficient portfolio management.(5)Effective risk transfer. A major concern of the ceding(re)insurer is whether it will receive credit for the reinsurance provided by the SPV. While approaches to the allowance of credit for reinsurance for the SPV contract vary across regulatory bodies, a common requirement is that there must be an effective, or real, transfer of risk in order for credit to be granted to a ceding(re)insurer.(6)Non-recourse. Investors should have no recourse to the ceding(re)insurer for repayment. If the SPV fails to generate adequate cash flows to service its debt(i.e., interest payments or repayment of bond principal at maturity), investors can only look to the issuing SPV.(7)Transparency of arrangements. This principle means that full transparency of the arrangements between the ceding(re)insurer and the SPV should be expected.SPV is separate from the bankrupt sponsor. In risk securitization SPVs are allowed to engage in few activities. Insurance securitization involves more management and business decisions. In such a case sponsors of securitization must make every effort to render the SPV “bankruptcy remote” or even “bankruptcy proof.” They should ensure the SPV’s independence. SPV should not be consolidated with the sponsor. A catastrophe bond should be structured so that no controlling interest exists. One of the mechanisms that have been developed is the Special Purpose Reinsurance Vehicle(SPRV). SPRVs are companies specifically established to facilitate the securitization of insurance risk. A PCC is a single legal entity. It follows from this that the core of a PCC and its cells are not separate entities. The main difference between a PC and a SPRV is that the SPRV is a separate company that holds the assets pledged to support obligations to the ceding insurer if a triggering event occurs. PCCs owned by insurers have therefore been formed to be used as Special Purpose Vehicles(SPVs) for securitization transactions. In such transactions, the PCC may issue bonds where the repayment is to be funded from the proceeds of the PCC’s investments. The PCC structure can be used as a platform for any type of Special Purpose Vehicle(SPV), including those established as transformer vehicles to support securitisations. The reduction in marginal cost is likely to give such institutions a competitive edge. Our country should take the special purpose reinsurance company system, but also maintain low cost.The fifth chapter is "the legal control of risk of catastrophe bond investors”. Catastrophe bonds pose unique risks to investors. The amounts and dates of their coupons and principal payments are inversely connected with the occurrence of insurance loss events. The assessment of the risks and value of the bonds is very difficult. To control the catastrophe bond investment risks, it is necessary of full disclosure of catastrophe risk and a high level of expertise.The transparency of a market should be assured by the legislator and overseen by supervisory authorities. Circ issued “Measures for the Administration of the Capital Replenishment of Insurance Companies(Draft)”.There is no clear stipulation of SPV’s obligation to disclose information. In terms of disclosure requirements, it does not reflect differences in catastrophe bonds and traditional securities. SPV acts as both reinsurers and issuer, so its disclosure should be compatible with the dual role. On-going reporting dialogue with supervisory authorities should not be unduly burdensome; however it should allow the supervisory authorities to monitor the ceding(re)insurer and on-going compliance of the SPV after authorisation.Investors possess sufficient expertise to analyze the risks of those securities, in order to be able to weigh the risks versus the returns. The Catastrophe bonds market is by no means appropriate for the direct participation of anyone except the most sophisticated investor. Intermediaries should ensure that Catastrophe bonds are suitable or appropriate to a particular customer. In the event that a registered insurer’s Catastrophe bonds investment has significant correlation with its underwriting portfolio, regulators should consider the appropriateness and necessity of imposing additional capital requirements on the insurer.